Caution Required For Formula And Supplements

Common themes exist for a2 Milk, Bubs Australia and Blackmores in their exposure to Chinese demand, and Wilsons sounds out the market while initiating coverage of the three.

-Niche infant formula products with functional benefits best positioned for growth in China
-Continued product development in supplements segment required
-Cost of doing business increasing in China for foreign brands

By Eva Brocklehurst

The revenue potential for infant formula and, more broadly, food & beverages in China, has been well flagged, although Wilsons suggests caution is warranted given the changes to Chinese sales channels and associated costs.

The broker initiates coverage on a2 Milk ((A2M)) with a Hold rating and $12.08 target, Bubs Australia ((BUB)), with a Hold rating and $1.30 target, and Blackmores ((BKL)) with a Sell rating and $70.30 target, in this sector.

Wilsons notes some common themes across the three, given their exposure to Chinese demand. A2 Milk is well-positioned to capitalise on the infant formula opportunity as it has a niche product, strong brand awareness and regulatory registration.

Nevertheless, the near-term warrants caution as the more direct distribution model in China is accentuated by uncertainty around the returns available from increased marketing expenditure.

Meanwhile, Bubs Australia is an emerging brand with significant potential, in the broker's view, as it has a niche product and multiple distribution alliances. However, the risk profile is elevated as brand recognition is being built.

While there is strong brand awareness of Blackmores the growth profile is challenged by China's regulatory structure which limits the company's prospects outside of online business, and there is heightened competition in food supplements.

The broker believes a2 Milk is the best positioned of the local brands to capitalise on the opportunity in China as it has multiple points of access to the consumer. The broker is less certain about Blackmores as its main channel, cross-border e-commerce, is being disrupted. The broker also considers the current share price excessive for the outlook.

Demographic Indicators

A declining birth rate in China since 2016 is the key headwind for infant formula demand and cost of living in major cities continues to be high relative to average income. Hence, the introduction of the two-child policy, while encouraging for the industry, may not be as significant as it appears.

In contrast, an ageing population provides the impetus for vitamins, minerals and supplement purchases, and the percentage of people above the age of 40 has increased to 48% in China over the last two decades from 31%.

While premium products feature as China's middle-class grows, the fact they are imported is no considered longer sufficient. Hence, Wilsons believes niche infant formula products with functional benefits, such as a2 Milk's product and goats milk are the best positioned.

A2 Milk sourcing is largely from Australasia. A2 milk is from dairy cows that are genetically tested for producing milk that only includes the A2 type of beta casein. Supply, particularly out of New Zealand, has increased substantially over the last five years.

The broker points out Europe has the most developed dairy goat sector and the Netherlands and Germany are major exporters of the milk. Australasia remains the next logical candidate with a "reasonable" goat dairy industry. However, there are constraints around supply of goats milk, as production per goat is significantly lower than per cow.

Product development is key for the supplements industry, which has a less sticky consumer profile. The broker cites the recent emergence of edible supplements that have functional benefits such as "anti ageing" as a fast-growing segment.

Wilsons also points out the Australian supplements industry has a higher cost base versus offshore peers, as Australia is the only country where manufacturers are required to produce to a pharmaceutical standard and certified for good manufacturing practice.

Channels

China has instigated increased scrutiny on social e-commerce and, in infant formula, the re-emergence of channels outside of the online segment and expansion in lower-tier cities are likely to be the next drivers of growth, in the broker's view.

Most of the conversion to online purchasing has now occurred and competition amongst e-commerce platforms has intensified. This highlights the importance of China's SAMR (State Administration for Market Regulation), which is required for infant formula sales.

The broker believes foreign infant formula brands that have an integrated channel approach are likely to be the most successful and “Mother and Baby” stores remain the dominant channel for the category. In this regard, the supplements industry does not have the same growth opportunities outside of online business because of a lack of consumer trust and the regulatory complexity.

Cross-border e-commerce remains the more important channel for foreign supplement brands. The broker suspects the supplements industry will go through a similar period of reforms to that which ensued for the infant formula industry in 2016/17 culminating in the introduction of SAMR.

The cost of doing business in China for foreign brands is also increasing along with heightened competition, especially for those mature brands transitioning from the low-cost daigou (product purchased outside China for sale in China) to a more direct distribution.

Wilsons assesses small daigous will fade out or consolidate into social e-commerce platforms because of low profitability and regulatory hurdles and the larger corporate daigous will need to partner with the platforms to stay compliant with the new rules.

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